Revolving credit – What is it and how do I use it?

Even for people who are familiar with what it is … revolving credit can be complex to grasp.

But once you get your head around it, revolving credit is a powerful tool that will help you pay down your mortgage more quickly.

You might have heard it works “like an overdraft” … but what does that mean? And how does it work?

A revolving credit mortgage is like a big bank account with a large overdraft. You can take out money, put it back, and keep doing this as long as you stay within your limit. Interest is charged every day, so if you put your paycheck into it, you can lower your loan amount for some time and save on interest costs.

In this article, you’ll learn exactly what a revolving credit is, how you set one up, and if using one could be the right strategy for you and your portfolio.

Do you have a question or comment about revolving credits? Feel free to leave your thoughts in the comment section at the end of the page.

What is a revolving credit?

A revolving credit is a type of mortgage, where a small part of your home loan acts like an overdraft.

But, if you convert part of your mortgage into a revolving credit – it’s an overdraft that’s already maxed out, and you still have to pay back.

Here’s how it works.

Let’s say you have a $500K mortgage. Now, chip off a chunk of that mortgage – say $10K … that’s your revolving credit.

But, rather than have a 15% interest rate like some other loans and overdrafts, it’s on a home loan rate, which is 4% or 5% in today’s money.

However, you only pay interest on money outstanding, not the money you have paid back.

So, if you have a $10K revolving credit, but have managed to put $4K in that account, you only pay interest on the outstanding $6K.

Types of revolving credits

There are two types of revolving credit:

• Reducing – the size of the revolving credit comes down over time

• Non-reducing – the revolving credit limit does not decrease over time

Effectively, a reducing revolving credit is like a Principal and Interest loan, where you are slowly forced to pay it off. For instance, over 30 years.

A non-reducing revolving credit is like an interest-only loan, where the size never decreases.

The danger with a non-reducing revolving credit is that you never pay it off and you have the revolving credit forever … if you’re not disciplined enough. But we get to that later.

How do I use revolving credit to pay off my mortgage faster? (In simple terms)

Before we get into the detail, here’s how you use a Revolving Credit to pay off your mortgage more quickly.

In its simplest terms, you use it as a goal-orientated savings plan.

Alongside making minimum mortgage repayments, you start putting any and all spare cash into your revolving credit – to pay it down quickly.

If you stick to the plan you’ll pay off the revolving credit and use that money to make a lump-sum payment off your mortgage.

Then you rinse and repeat until you’ve paid off your mortgage.

This is called the Mortgage Buster strategy.

There are additional benefits (as well as drawbacks) but as you pay money into the revolving credit, you reduce the interest you’re charged. But, like an overdraft, you can also take that money out at any time.

Let’s get into the pros and cons.

More from Opes:

• Offset mortgage - What is it and how do I use it? (Article)
• The split banking strategy - Use this to improve your equity (Article)
• How to pay down your mortgage faster - The Mortgage Buster Strategy (Article)
  

What are the pros and cons of using revolving credit?

If you ask a mortgage broker, most will say everyone should use a revolving credit … but only if you use it properly.

Here’s why.

Pro – revolving credits are flexible

Revolving credits are flexible. In technical terms, they are liquid.

Any money you put in can be taken out, the same as any other bank account.

That’s why many borrowers will put all their salary and wages into their revolving credit, and then pay their expenses out of this account.

While they have money in there, the amount of interest they pay is temporarily reduced.

Some investors find this flexibility really pushes them to pay down that mortgage more rapidly, with the comfort of knowing that you can access that money in an emergency.

For instance, if you’ve managed to put $10,000 into your revolving credit but then your car breaks down – you can take that money back out to cover repairs.

If you were to do that with your standard P+I loan, not only are you limited to how much extra you can pay back (5% for most banks without incurring fees) you will have to apply to get that money back out if you need access.

Con – revolving credits are more expensive

Revolving credits come on a floating interest rate. On average floating rates have historically been about 0.91% higher than the one-year fixed mortgage interest rate (2002 – 2022).

So, on average, you’ll pay a bit more in interest if you use a revolving credit.

This is why you wouldn’t set up your entire mortgage on revolving credit, even if you could (you often can’t btw), because then you'd be paying the whole mortgage on a much higher interest rate.

That’s why your mortgage broker will advise on an appropriate revolving credit amount.

Said another way, a mortgage broker will help you figure out what you can realistically afford to pay back to help make some headway on paying off a mortgage.

The minimum amount is $5,000, and the maximum is $200K to $250K, depending on the bank.

Yes, you are going to pay a higher interest rate on your revolving credit, but once you make that repayment back into you mortgage account you are going to save some pennies on interest there.

How do I use revolving credit as a part of my overall mortgage strategy?

The best way to use a Revolving Credit to pay down your mortgage faster is to use the Mortgage Buster strategy.

Put simply, the strategy is to use a revolving credit to make extra discretionary payments on your mortgage to pay it down more aggressively.

In turn, this increases the amount of equity you have in a shorter period of time – so you can buy more investment properties.

It also decreases your debt, so it improves the income and expenses side of your mortgage application.

So, how do you set up a revolving credit?

The best action plan is to go through a mortgage adviser, but you can go directly to your bank.

The first step is to figure out how much extra money you can realistically put towards paying off your mortgage within a year. That’s the amount you’ll set your revolving credit up for.

For instance, let’s say you can put an extra $300 away a week. This adds up to $15,600 in a year.

In this instance, you’d typically break off $15K from your mortgage (we’ve rounded for simplicity) and put it in the revolving credit.

This revolving credit now works like a transactional account. All your wages go into it, and all your bills go out. What’s left stays in there and gradually pays it off.

The available balance starts at zero. So, you save $300 one week and you’re at $300; in a month you’re at $1200 … and so on.

At the end of the year, when you reach your $15,000, you put this entire amount back into your main mortgage.

Here’s a graph that models how much more quickly you can end up paying your mortgage off by using revolving credits.

By setting up your mortgage this way you are setting yourself a goal of how much extra you want to save in a year.

However, there is much more flexibility than with say a higher repayment or a loan, because you can take money in and out as easily as a transaction account.

A note on strategy

It’s important to note, a revolving credit is going to be just one part of your overall strategy to pay down debt.

Generally speaking, the set-up for an investor will look something like this:

• 2 investment properties on interest-only loan

• The bulk of 1 personal mortgage on principal and interest

• Revolving credit with all your discretionary spending.

3 Other creative ways to use revolving credit

You don’t just have to use a Revolving Credit as part of the Mortgage Buster strategy.

Revolving credit works really well for people who know they have a certain amount of money to spend, but only need to spend that money slowly.

So, let’s go through 3 scenarios where you could also use Revolving Credit.

#1 – To get the deposit for a new build investment property

Let’s say you’ve got your eyes on a New Build investment property – you can use a revolving credit to help you get there.

The classic strategy is to set up the 20% deposit you’ll need to purchase the New Build as a revolving credit.

This is because you need a 20% deposit to buy this property, but you only pay 10% straight away, with the other 10% to be paid at settlement.

Using Revolving Credit means you have access to the first part of the deposit immediately. But, you’ve already secured the other 10% that you’ll need by the time your New Build is complete.

Just make sure you leave the other 10% to use in 12 to 24 months time when the build settles. Don’t spend it on a new wardrobe full of shoes or a holiday to Bali!

#2 – To fund your renovations

Let’s say your mum wants to renovate her existing property. In this instance, she could take out a $50,000 loan, withdraw all the money at once, and go for gold at Bunnings.

But the issue here is not all of her expenses are going to come up all at the same time. The nature of renovations, like many projects, is money must be spent as you go.

But, if you take out a full $50k loan as a mortgage top-up you have to start paying interest on the full $50k straight away.

So, even though she is spending the money slowly, she is still paying the interest on the full $50K.

This is why it could be a good idea for her to set up a $50,000 revolving credit secured against her home.

This way, she can take money as she needs it and she’ll only be paying interest on the money as she spends it.

But … isn’t this just a loan?

In case you’ve got this far and you’re thinking: “Isn’t this just a loan with a fancy name?” Well, no, there are key differences.

Firstly, revolving credits work really well when you know you have a certain amount of money to spend, but you don’t have to spend it all in one go.

This is because you pay interest on the money you actually spend, rather than interest on the entire amount.

For instance, let’s go back to our renovating mum. If she took out a loan for $50,000 she’d have to pay the interest on that loan – the full $50,000 – on a fixed rate, regardless of the fact that she’s going to spend it in increments.

But, with a revolving credit, you only pay interest on the money you actually spend.

#3 If you’ve got cash sitting in your bank

Using either a revolving credit or an offset account is not just useful when paying down your mortgage aggressively.

It can also be useful when you have money squirrelled away in different accounts.

For instance, let’s say you have $2,000 in an emergency fund or $5,000 saved for a holiday.

Even if you don’t formally pay this money off against your mortgage, you can still use it to help reduce the interest you pay by transferring it into your revolving credit or offset account before you use it.

This helps to keep the interest you’re paying as low as possible in the meantime.

Common mistakes when using revolving credit

Earlier in the article we listed a revolving credit’s liquidity as one of its pros. However, this flexibility can also work in the other direction.

This is because the voluntary money you’ve saved is not locked away behind the bank’s bars. Instead, it’s there for you to freely and all-too-easily take out and spend.

This is why some people, who want to pay down their mortgage quicker, would rather just up their minimum mortgage repayment. Once it’s paid out, there’s no easy way to access it.

This is similar to other more forced saving schemes like KiwiSaver. This is money that is squirrelled away every paycheck.

Yes, you can access it for certain purchases, but they have specific guidelines attached to them; e.g. hitting retirement, buying your first home, or if you are in financial hardship.

This is why some financial advisers call them “revolting” credits, because they don’t always work as well as they should on paper.

It all depends on your money personality, and how disciplined you are.

Revolving credit vs offset account – what’s the difference?

An Offset Account is an alternative to a Revolving Credit. It has similar benefits but it works a bit differently.

The main difference of an Offset Account is that it’s two accounts:

• A loan account

• An offset account (or accounts) you put money into

Said another way, rather than just one account with a revolving credit that sees money come in and out, separate accounts offset each other.

How it works is – your mortgage is put on a floating rate in one account, which is offset by the sum of the collective money in other accounts.

For instance, let’s say you have $30,000 in your loan account, and $20,000 in the offset accounts.

In this scenario you are only charged interest on the $10,000 difference, or the part of your mortgage that hasn’t been offset.

Which one should I choose?

Offset or revolving credit – which one will depend on the conversation between you and your mortgage broker.

And it should be pointed out that banks typically offer one or the other. Either they have a revolving credit, or an offset. So you may not always have a choice about which one you go for.

But generally speaking, here’s the type of people suited to each model:

Offset accounts work great for people who like to bucket money.

So, if you’re the type of person who likes to have separate accounts for: holidays, furniture, school fees, savings – then an offset account is going to work for you.

Whereas a revolving credit is much better for people who keep to a strict budget.

When you’re this type of person, you’ll suit having a revolving credit in one account because you’ll only spend what you set out to and the rest will build up.

It’s important to differentiate between a personal and investment loan.

An offset account is a better option for investors, because of interest deductibility.

However, a revolving credit is better for a personal mortgage. Not only does the deductibility not matter, but once you pay down the revolving credit your repayments stop as well.

With an offset account you can have the entire amount offset but still have to make additional repayments. Yes, they’ll be at 0% interest, but still – they’re there.

Who is a revolving credit the right fit for?

While there are some who would claim the revolving credit is the “greatest invention the mortgage industry has ever seen”... it’s not the right fit for everyone.

As we’ve said, the flexibility a revolving credit provides can also be its downfall.

You’ve got to be disciplined, otherwise you risk spending all this money you have so diligently saved.

So, if you’re not disciplined with your money, it’s not going to be the right fit for you.

Similarly, don’t get a revolving credit if you are only going to make minimum repayments. It makes no sense in this instance.

If you think you’re someone who would struggle not to spent your extra money, why not consider just upping the mortgage payments so you can’t touch them (easily) once they are gone.

But if you’re a disciplined spender, you’re determined to aggressively pay down your mortgage, and you find encouragement from having a goal to meet – then yes, this might be a good fit for you.

In this case, it might pay to have a conversation with your mortgage broker about setting up a revolving credit.